FLASH UPDATE: TRV Weekly Commentary - Rate Normalization?

TRV Weekly Commentary

Week Ending 18 Feb 2015

Comment:

We saw quite a bit of market activity this week pre and post FOMC minutes. The rates market continues to focus on the tone of the minutes to infer when a normalization cycle will commence. Investors and the sell-side community generally anticipate a summer rate hike that has caused the yield curve to flatten over the past year with higher short-term rates and a strong global relative value story on the US 10yr. The minutes this week, however, reflected that FOMC participants are inclined toward “keeping the federal funds rate at its effective lower bound for a longer time.” The dovish tone sent 10yr yields about 8 bps lower before ending the week 6 bps higher at 2.08%. Despite the action in the 10yr, the true story in rates is the 9 bps of yield curve steepening which is beneficial to the carry component of MBS.[1]

With 10yr yields backing up 6 bps, MBS outperformed the benchmark 3 ticks while slightly underperforming the swap curve. We are relatively neutral on the basis given our bullish stance on vol due to European headlines, low inflationary prices and increased uncertainty as to the timing of a rate normalization policy. If the curve reverses this week’s movement, we would anticipate down in coupon swaps to perform well and for specs to outperform TBAs on reignited refi fears and increased desirability of call protection.

That said, the refi index fell 16% this week to a point that lies 27% below January’s peak. Much of the decline is attributable to the bear steepening of the curve we have seen as of late. In addition, savvy borrowers have likely taken advantage of January’s sharp decline in mortgage rates, which should cause a decreasing rate of refi applications. The decline in the refi index and the bear steepening yield curve provided tailwinds to IOs this week. Benchmark IO 4s were particularly penalized in January’s rate rally and so we have seen this sector outperform other IO sectors. Vendor OAS shows this sector has tightened between 5 and 38 bps.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

---

[1] A steeper yield curve implies higher mortgage rates in the future, thus reducing prepayment expectations. We ran a FN 3.5 TBA using a live swap curve at the current market price and obtained an OAS of -5 and a long-term CPR of 13. We then re-priced the same bond with a 50bp steepening scenario and calculated an OAS of -27 and a long-term CPR of 8 that coincides with a 50-80 bp higher MBS current coupon.

FLASH UPDATE: TRV Weekly Commentary - Rate Volatility Will Persist

TRV Weekly Commentary
Week Ending 11 Feb 2015

Comment:

The impressive US non-farm payroll headline defined the week’s risk-on tone and was the driving force behind the yield curve. January NFPs came in strong at 257 versus 228 consensus, but more noteworthy was the two-month payroll net revision of +147k. Yields soared with the 10yr ending the week 27 bps higher, equivalent to 78 ticks of price decline. Despite higher rates, vol remained stable.  We suspect this will be short-lived, as US headlines will likely take a back seat to geo-political concerns.

With the refi index printing 274 points lower, prepayment fears beyond the April print have subsided, leaving interest-only paper tighter. Benchmark FN4 IOs of 13, for example, narrowed 120 basis points. This is equivalent to an outperformance of 5.4%, erasing half of the January widening. To no surprise, up-in-coupon trades also performed extremely well. FN 4.5s outpaced the stack, having tightened 12 ticks versus the curve. Additionally, rolls strengthened into 48-hour day with FN 4.5s increasing 1.5 ticks. For now, the TBA market has been rate-directional. We would like to point out that convexity levels are much higher: investors need to be weary of both sharp sell-offs and rallies as convexity hedging may come into play. We are neutral on the basis for the time being given the asymmetrical risk.

This week, the market again viewed the world as riskless, as investors seemed to have forgotten about the global growth glut, declining energy prices and growing economic frictions within the Euro Zone. We note that we are one headline from a risk-off market, and even a partial reversal of this week’s rate movement could reignite refi concerns. Our view is that rate volatility will increase as we move closer to ground zero of the hiking cycle.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: TRV Weekly Commentary - Rates Approaching All-Time Lows

TRV Weekly Commentary
Week Ending 04 Feb 2015

Comment:

The rates market appears relatively calm on a week-to-week basis; we saw the curve bear steepen by 2 basis points with mortgages relatively flat versus the curve. Rates however whipsawed drastically around month-end with 10yr yields falling within inches of an all-time low. Swap volumes were running about 200 percent above average with flows skewed toward receiving across the curve. The catalyst for the market actively was largely a disappointing Q4 GDP print (2.6% versus 3.0% expectations) and Russia’s surprise decision to cut rates by 200 bps. The benchmark 10yr ultimately snapped back 11 basis points to yield 1.75% in the days following the turmoil.

Mortgages lightly underperformed rates across the coupon stack into month-end as origination picked up. We saw quite a few days of 3+ bln in issuance in tandem with low rates. Mortgages later rallied between a half to 2.5 ticks before ending relatively flat. We would like to point out that the G2/FN 4 swap fell drastically following the FHA’s announcement that it would reduce the Mortgage Insurance Premium (MIP) by 50 basis points. In our opinion, the swap was over chastened and has rallied 5 ticks from an intraday low of -17 ticks. We continue to follow the swap’s performance.

The refi index increased 2.5% this week despite recent declines in Treasury yields. The MBA 30 year mortgage rate decline a mere 4 bps, helping to suppress the refi index. The real refi story is that FHA refi applications picked up 76% on a seasonally adjusted basis due to the MIP decrease. The surge in applications is likely due to pent-up demand as servicers ramp up their solicitation efforts. We note that servicers are not at capacity as staffing levels are little changed from late 2012 when the refi index was much higher. Additionally, we would look to primary/secondary spread widening as early signs of capacity constraints, yet the spread has remained relatively range bound.

As the FHFA contemplates reducing principal on properties with depressed values as approximately 10% of homeowners have negative equity, policy risk remains high. Additionally, investors are also focused on a potential HARP extension. We estimate that $91 bln of loans have LTVs greater than 80 and have more than 100 bps of rate incentive. A year ago, that number was only $42 bln when Mel Watt said HARP extension was off the table. The HARP extension thus seems more plausible and would likely cause significant widening of eligible collateral.

The resulting increased refi risk continues to cause IO OAS to widen. The chart below shows that vintage is an extremely relevant as 3.5s of ’13 have a much higher risk premium than do 3.5s of ’12. We also note that 4s of ’13 continue to have the highest risk premium as they have the greatest rate incentive, are less seasoned and are less prone to refi burnout. The recent widening has presented significant opportunity in the space and we anticipate volatility and policy risk will continue to drive our markets.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: TRV Weekly Commentary - Vol & Refi Fears

TRV Weekly Commentary
Week Ending 28 Jan 2015

Comment:

The yield curve continued to bull-flatten post January Fed minutes in contrast to numerous 2014 projections. We interpreted the tone of the minutes as more dovish than recent months and point to “Market-based measures of inflation… have declined somewhat substantially” as evidence of the tone. We note that January’s statement replaced “somewhat further” with “substantially”, giving indication that the 2.0% inflation target may continue to run below mark. Investors agreed with our interpretation of the Fed’s statement as yield on 10yr Treasuries fell 7 bps to an intraday low of 1.70%.

The mortgage market was strong leading up to the Fed’s announcement, with lower coupons outperforming the 10yr by 7 1/8 ticks, and higher coupons outperforming by 4 5/8 ticks. This was largely due to rising yields and short-covering given the previous week’s weakness. However, the magnitude of Syriza victory in the Greek elections led rates between 3 and 5 bps lower. The Syriza party is known for anti-austerity sentiments that could potentially be damaging to the Euro Zone.

In the days leading up to month-end, rates dramatically fell and renewed refi fears. The refi-index shows no change this week due to how the week fell in the calendar. We expect an uptick in the index, however, as rates approach all-time lows. Rate volatility has spurred a significant amount of trading: about 9 billion of Agency derivatives went out to bid with ¼ not trading. “DNT” (did not trade) is an indicator of widening spreads and decreased liquidity as bids do not meet reserve levels. Post-HARP GN collateral fared the worst (-11%) given the 50 bp reduction in mortgage insurance premium while conventional TBA collateral was likewise hit hard (-8%). Benchmark IOs behaved as expected, widening between 40-100 bps depending on vintage. We expect continued opportunity in the sector as most derivative books are likely down between 5 and 8% unlevered, erasing a large portion of their 2014 gains. 

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

FLASH UPDATE: $50 oil is worse for consumers than you think

The price of crude oil has fallen approximately 55% since June.  At the same time production is hitting all time highs...Supply and demand tells us that we could be setting up for more downside in the energy complex.  For many reasons, overall rig count is down 15% since October 2014, matching the lowest levels since October 2010.  The Bakken Shale and Permian Basin, where horizontal drilling has been the primary method used in the tight rock formations, have seen significant shut downs.

Producers have already guided that spending in the US & Canada will be 30-35% less than last year. Internationally, Qatar Petroleum & Royal Dutch Shell canceled plans for a $6.5 B petrochemical plant, due to the JV becoming "commercially unfeasible" in the current energy market.  This is after Qatar announced a $6 B project cancellation in September as well.  Statoil ASA also announced a delay in an offshore drilling project.  Cost cutting and delaying investment has already started selectively.  Something has got to give soon...

Schlumberger just announced that they cut 9,000 jobs at the year end.  They took $1 B in charges in Q4, $300 mm of which directly related to downsizing staff.  Separately, three contract drillers that we are aware of recently had clients terminate rig contracts early.  One of them layed off 700 employees unexpectedly.  A senior economist at the Dallas Fed said that Texas could lose 140,000 jobs if crude stayed below 50% of the 2014 average.

The Perryman Group estimated that the energy industry generates $1.2 T in gross product annually, as well as providing 9.3 mm permanent jobs.  Since Dec 2007, 1.36 mm jobs have been gained in shale oil states vs -424 k in non-shale oil states.  Please read that last sentence again.  This is much worse for the consumer than you may think.  The consumer is already on weak ground, and a major loss of jobs & confidence could be a death blow.

Depending on the index, ETF or mutual fund, energy makes up 15-25% of high yield exposure. Marty Fridson calculated that 18.1% of high yield energy issues are already trading at distressed levels (vs 8.45% overall and 4.16% overall excluding energy).  This pain in the energy sector of the high yield market could be the catalyst we have been waiting for to set things off.  I have no doubt that if crude remains low, this will be a major blow for the economy and the consumer.  We are excited that we've been able to add to positions above par while "all is well" outside of energy.

We are back!  Enjoy the long weekend and Happy New Year to everyone.  Please reach out to investorrelations@thetradexgroup.com to receive an invitation for our next webinar on "The State of the HY Market", presented by our Senior Advisor, Dr. Edward Altman

Best regards,

Richard Travia
Director of Research.

FLASH UPDATE: TRV Weekly Commentary - Opportunity in IOs

TRV Weekly Commentary
Week Ending 17 Dec 2014

Comment:

This week was an active week in trading, particularly in commodities, rates and MBS derivatives on market turmoil. Below are some highlights that have contributed to the increase in vol this week:

• WTI crude futures reached an intraday low below $55/barrel on the Tuesday (see graph)
• The Russian ruble depreciated to a high of $79.16 USD from $64.23 USD (see graph)
• The Swiss National Bank imposed a negative 4.6 bps deposit rate on Thursday
• The FOMC meeting minutes reflect a close monitoring of inflation and the “transitory effects of lower energy prices” on Wednesday
• The 10/5 spread compressed 8 bps
• The 10yr reached an overnight low of 2.01 on Tuesday

Implied vol on 10yr swaps increased 3 ticks on these data points and we saw equities, spread and credit products sell-off. The market turmoil largely began due to lower energy prices, causing the Russian Ruble to depreciate substantially. From there, a domino effect insured with the S&P500 selling off 2.64%, the mortgage basis underperforming by 4 to 9 ticks versus 10yr hedges, and IOs cheapening between 10 and 64bps of OAS.

In IOs, we argue that it may be an opportune time to be in the market as the underlying fundamentals are intact and refi risk is contained. A meager drop in mortgage rates and an unchanged refi index support this thesis. We see the best opportunity in 3.5s of ’13 as the IO benchmark widened 64 bps this week. Another potential opportunity lies in RMBS as 60+ delinquencies are generally declining, LTVs have been improving, and dealers have inventory in their balance sheets that can be cleaned up before year-end. We have seen some paper with strong credit support and stable cash flow selling for LM70s that may be sourced cheaply.

As we prepare to launch in the next couple of weeks, we look forward to future market dislocations that will provide opportunities in our markets.

Regards,

Tradex Global Advisory Services, LLC

investorrelations@thetradexgroup.com 

203-863-1500

@Tradex_Global

Russian Ruble vs WTI crude futures

Contagion! Is that still a word?

Liquidity in the lower rated junk bonds has already started to become tentative at best.  Over the last few months, volatility has risen significantly and a true reassessment of risk has begun with investors.  Bid-ask has been gappy and inconsistent, both on the downside and upside.   It has been fairly obvious for a long time that investors are not being compensated properly for the risk that they are taking on in the high yield market, particularly in the CCC-rated sector.  As pain from the energy sector spills over into the rest of the high yield market, and illiquidity becomes a reality, investors may soon be met with a reminder about what the word “contagion” means. 

HYG & JNK are trading at 2 year lows, and retail investors who blindly own high yield for the “safety of fixed income” are likely scratching their heads, as they wonder why and how their investment can lose in price.  They probably thought that it was just a safe yield that they could bank on.  30% of high yield ETF holders are hedge funds, and they will move the needle quickly when trying to avoid any losses from a headline risk type of trade, such as being long high yield.  Outflows have not started yet in these two ETFs, but if the past is any indicator, outflows will be large and fast.  July 2014 saw $12.6 B of overall high yield outflows; the impending problem could make July pale in comparison. 

As contagion takes hold, the illiquidity will likely become an exponential problem, as liquid equity ETF structures and daily dealing mutual funds struggle to create underlying bond liquidity, especially at a NAV that doesn’t represent significant gaps.  Once those gaps start to become apparent, trust is quickly lost in the structure itself.  NASDAQ released a white paper earlier this year, citing liquidity as the #1 ETF myth that could lead to investor losses. Lower rated high yield paper is starting to roll over…how will you be positioned? 

Enjoy the football today,

Richard Travia

Director of Research